Cash isn’t what it used to be

If SA can’t get its budget deficit under control, how do investors preserve their capital?

Warren Buffett’s famous first rule of investing is ‘never lose money’. His second rule, of course, is ‘never forget rule number one’.

Identifying investments where you can be sure that you won’t lose money in the current environment is however extremely challenging. Buffett’s Berkshire Hathaway currently has more than $130 billion in cash because it is finding it so difficult to find appropriate opportunities.

‘Preserving capital, at its core, is about maintaining the buying power of what you have,’ said Andrew Lapping, the CIO at Allan Gray and co-portfolio manager of the Allan Gray Balanced fund and Allan Gray Stable fund. ‘This is where cash comes in. A lot of people see volatility as risk, and so they find cash attractive. But the real risk is a permanent loss of buying power.’

Locally, cash has been an outstanding investment over the past few years, as inflation has averaged around 4.5% while money market funds have been returning as much as 7.5%. A 3% real return has therefore been extremely attractive. This is particularly the case as local equities have struggled.

However, this kind of real return from cash is extremely unusual. It has also quickly been eroded in the last few months as the South African Reserve Bank has cut the interest rate by 275 basis points.

Fiscal trouble

‘The even bigger risk,’ said Lapping, ‘is how South Africa gets itself out of its current fiscal position. There is a huge budget deficit, relatively high debt-to-GDP and very little economic growth.’

How does the government avoid this becoming a negative spiral from which it is impossible to escape?

‘They could cut spending extremely aggressively, but that is very hard to do in any country, and particularly hard in South Africa,’ said Lapping. ‘They could increase tax rates substantially. But, again, that’s tricky – corporate tax is going to take a long time to recover and personal income taxes are already relatively high in South Africa. Or they could increase consumption taxes. None of these are particularly palatable.’

The risk, if the country is unable to get the deficit under control, is that inflation could pick up substantially.

‘Examples of how this happens range from the relatively extreme in Argentina to the very extreme in Zimbabwe,’ said Lapping. ‘These are countries that just couldn’t control their spending. And in a case anywhere close to that you don’t want to be in cash, because money in the bank can very quickly lose its value in a high inflation environment where interest rates don’t respond accordingly.’

So many ways to lose money

How then, do investors respond? How do they preserve their capital?

‘The traditional way to protect your assets is to own real assets such as commodities, property, or equity,’ said Lapping. ‘The problem with equities is that in South Africa valuations are cheap on the face of it, but obviously there are very high risks. Equities in global markets, and particularly the US, on the other hand, are relatively highly-valued. And another sure way to lose money is to buy expensive assets.’

For Lapping, preserving capital over the long term requires buying undervalued assets, with ‘staying power’. The first obvious place to look is the local bond market.

‘You can buy South African government bonds at a 10% to 11% yield, which is pricing in quite a lot of bad news,’ he said. ‘And if inflation goes up to 8% you’re still getting a 2% real return, which isn’t bad over the long term.’

Developed market bonds, however, don’t offer the same long-term comfort.

‘Given government debt burdens and zero yields, developed market bonds are extremely risky, because you are getting no return and governments are monetising their debt,’ said Lapping. ‘At least in South African bonds you have an interest rate buffer. In developed markets there is no buffer.’

Global view

Finding opportunities in equity markets is, however, far less clear cut. Often it is about looking for the ‘least worst’ option.

‘In the global market, you’ve had just a few big winners,’ said Lapping. ‘In the US that’s the likes of Microsoft and Amazon.

‘People know that Amazon is a great company, but the price is massive and it’s not worth it,’ said Lapping. ‘What you need to find is good businesses where the price makes sense. You can’t only say I’m looking at price, because then you will buy a portfolio of junk. You also can’t just buy great businesses, because then you have a portfolio of assets at high valuations.’

There are some pockets where these opportunities may be available.

‘Where our partners Orbis are looking for value is in unfavoured areas, in places like Europe where you can buy great businesses on very reasonable valuations because there is so much uncertainty.’

There are some similar opportunities in South Africa, although they are harder to find.

‘The risks here are more acute,’ said Lapping. ‘For instance, banks are very cheap, but they are leveraged financial institutions and bad debts will no doubt go through the roof. But we do think that selected industrial stocks like Tiger Brands or AVI, which are pretty defensive companies trading on valuations well below their long term averages, are interesting. These are businesses that should survive and don’t have much debt. Logistics company Supergroup is another well-run business, which is the type of thing that you have to try to find.’

Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.

This article was first published on Citywire South Africa here, and republished with permission.